Suppose the Bank of Canada pegged the price of gold. If an increased demand for gold caused a recession, would macroeconomists be told they needed to pay more attention to the theory of the demand for gold? Or would the Bank of Canada be told to change its policy?
Suppose the Bank of Canada pegged the exchange rate to the US Dollar. If a fall in the demand for Canadian-produced goods relative to US-produced goods caused a recession in Canada, would macroeconomists be told they needed to pay more attention to the theory of international trade? Or would the Bank of Canada be told to change its policy?
Suppose the Bank of Canada pegged the money supply growth rate. If an increased demand for money caused a recession, would macroeconomists be told they needed to pay more attention to the theory of the demand for money? Or would the Bank of Canada be told to change its policy?
In each of those three cases, the macroeconomic importance of some particular sector of the economy is merely an artefact of a particular monetary policy.
Is the macroeconomic importance of finance, likewise, merely an artefact of a particular monetary policy?
What lesson should we learn from the recent recession? Is it that macroeconomists should pay more attention to finance? Or is it that we should change monetary policy?
In the past, the lesson we learned is that we should change monetary policy. When fluctuations in the demand and supply of gold became macroeconomically important, we dropped the gold standard. When fluctuations in the trade balance became macroeconomically important, we dropped fixed exchange rates. When fluctuations in the demand for money became macroeconomically important, we dropped money growth targeting. When fluctuations in finance became macroeconomically important, what should we do? Why should this time be different?
Now, the analogy is not exact. The Bank of Canada does not peg a nominal interest rate, except for 6-week periods. It adjusts that nominal interest rate peg eight times a year, as needed, to try to peg the CPI inflation rate. But interest rates, in particular the gap between market rates of interest and their corresponding "natural" rates of interest, play a key role in monetary policy tactics. And the monetary policy strategy, targeting 2% inflation, can be seen as pegging the real rate of interest on currency at minus 2%, which is the interest rate differential between holding currency and holding the CPI basket of goods. Current monetary policy uses one interest rate differential as an instrument to target a second interest rate differential. Current monetary policy, in both tactics and strategy, is all about interest rate differentials. And the theory of interest rate differentials is finance. A financial crisis is a big sudden change in interest rate differentials.
It doesn't have to be this way.
In the past, we changed monetary policy to make the demand for gold, the trade balance, and the demand for money, macroeconomically unimportant.
We should now change monetary policy to make interest rate differentials macroeconomically unimportant.
Worthwhile Canadian Initiative 
I noticed you switched from “increased demand for” to “fluctuations in”, probably because it doesn’t really work for the analogy you’re making. It’s hard to argue that increased demand for the CPI basket causes recessions.
Kailer, it’s easy to argue that an increased demand for the future CPI basket causes recessions. Assuming the price of the current CPI basket is predetermined, inflation targeting is essentially targeting the price of the future CPI basket. If the target is too low, you get a recession, just as you get a recession when you target the price of gold too low.
Kailer: I kept, um, fluctuating back and forth when writing the post. The logical way to write it would have been “Fluctuations in X cause business cycle fluctuations.” But I wanted to be a bit more concrete, to make it more readable. My biggest problem was money growth targeting. Because when the Bank of Canada actually did that, in the late 1970’s, it was a fall in the demand for money, which caused inflation to be too high, rather than a recession, that led to the Bank of Canada abandoning money growth targeting.
Andy: Hmm. Good point. I’m thinking up a follow-up post, on why inflation targeting failed, seeing IT as pegging the interest rate differential between currency and the CPI basket.
Re making “interest rate differentials unimportant”, Warren Mosler advocates a permanent zero rate, and I agree. Milton Friedman also argued that governments / central banks should not issue any interest yielding debt: i.e. the only liability they should issue should be base money. And that implies an end to interest rate adjustments, or at least a downgrading of their importance. Plus a recent Fed study claims that the relationship between interest rates and investment is tenuous. For Friedman see paragraph starting “Under the proposal..” (p.250) here:
Click to access friedman.pdf
For the Fed study, see:
Click to access 201402pap.pdf
More arguments against interest rate adjustments:
1. They are distortionary: that is, assuming they work, they influence just borrowing and most of the money borrowed goes on investment spending. And there is no good reason to effect stimulus by upping just ONE FORM of spending. We might as well try escaping recessions by boosting just car factories and restaurants.
2. There is presumably an optimum or free market rate of interest. Unless someone can prove market failure, then interfering with that free market rate will be a misallocation of resources.
Nick, the way your story is structured, it implies that we give up on X(n) and move on to X(n+1), which causes a new set of problems, so we move on to X(n+2), etc. So if we give up the current strategy and move on to the next strategy, what are the new problems that will arise which will cause us to move on to yet another strategy?
Nick asks “When fluctuations in finance become macroeconomically important” should we “pay more attention to finance?”. The answer is obviously “yes”. That’s what Dodd-Frank and the Basel rules are all about. But the trouble is that D-F and the Basel lot have achieved nothing, except let private banks run rings round them.
As regards the “fluctuations” to which Nick refers, they can be greatly reduced by the simple expedient of enforcing a big increase in bank capital. In fact Milton Friedman, Lawrence Kotlikoff, James Tobin and others advocate/d that institutions that lend should be fund ONLY by shareholders or other loss absorbers: i.e. that there should be no leverage.
The advantage of that (or at least greatly increased capital ratios) is that banks cannot suddenly collapse. Reason is that if they make silly loans, all that happens is that the value of their shares fall. And as Mervyn King pointed out in his Bagehot to Basel speech, stockmarket setbacks have nowhere near the devastating effect that bank collapses do.
“And the theory of interest rate differentials is finance. A financial crisis is a big sudden change in interest rate differentials.”
Nick, the proposition of your post depends on these two definitions, doesn’t it?
Are these your own home grown definitions, or do you see them as obvious and generally accepted?
Very interesting construct in terms of the two interest rate differentials. That seems quite intuitive and difficult to question.
Interesting post. Yup, banks became the problem. Their weight in economy has to be decreased.
JKH: I just made those definitions up! But I’m not sure if they are really definitions, or just statements that most people would accept. For example, if a student was really interested in understanding interest rate differentials, I would recommend a course in finance. I think most people would.
Ralph: If we were on the gold standard, and if large fluctuations in the demand or supply of gold caused macro problems, we could try to stop those large fluctuations. Or we could admit that we would fail, and drop the gold standard instead.
Tom: that’s the right question to ask. But it’s going to need another post to answer.
The US did not drop the gold standard because of strange fluctuations in the price of gold, it dropped it because it was a Ponzi Gold Standard that was failing. People were taking out their gold and the Fed had issued 2.5 times as many paper notes as it had real gold backing them. The Fed would have been bankrupt if they did not drop the Ponzi Gold Standard.
http://howfiatdies.blogspot.com/2010/11/feds-ponzi-gold-standard.html
Vincent “The US did not drop the gold standard because of strange fluctuations in the price of gold,…”
I didn’t say it did. If the central bank pegs the dollar price of gold, then by definition the dollar price of gold cannot fluctuate. But fluctuations in the demand or supply of gold will cause macroeconomic instability, precisely because the price of gold cannot fluctuate.
Ok. You said, “When fluctuations in the demand and supply of gold became macroeconomically important, we dropped the gold standard.” The problem was that the way the dollar was linked to gold was only with 40% backing. So even though there was a definition/peg of $20 dollars to 1 oz of gold, it was not a peg they could defend. Once people started getting worried then there was a run on gold and they had trouble. First they closed gold to the local population and then later to foreigners as well. It is really very much like Argentina trying to hold a peg to the dollar while they keep printing more local money. At some point it will fail.
Nick,
Those are interesting definitions and/or statements about finance.
I wonder if your construction is a bit circular though.
I think your view (simplified) is that interest rates are not a good way to think about monetary policy.
Your characterization of finance seems to imply that interest rates are a good way to think about finance.
But just as there may be a tug-of-war in how to think about monetary policy as between interest rates and money, maybe there’s a tug-of-war in how to think about finance as between interest rates and financial assets.
I’ve taken a few finance courses in my time, but here’s the opening paragraph of Wiki on it:
“Finance is the allocation of assets and “liabilities over time under conditions of certainty and uncertainty. A key point in finance is the time value of money, which states that a unit of currency today is worth more than the same unit of currency tomorrow. Finance aims to price assets based on their risk level, and expected rate of return. Finance can be broken into three different sub categories: public finance, corporate finance and personal finance.”
Interesting. I tend to think about finance in that order also – asset and liability mix before interest rates (and the cost of equity of course).
But I tend to think about monetary policy in the reverse order – interest rates before money balances.
Does that confusion make any sense to you?
🙂
JKH: what you say there makes sense to me. I’m equally confused! I think of interest rates as somewhere on the border between micro and macro, but interest rate differentials as very much a finance topic.
Vincent: yes, with 100% gold reserves, the central bank can maintain gold convertibility if it wants to. But would it want to, if the cost is macroeconomic instability.
“Suppose the Bank of Canada pegged the price of gold. If an increased demand for gold caused a recession, . . .”
It causes a recession because the Bank of Canada sells gold, which drains money from the economy?
“Suppose the Bank of Canada pegged the exchange rate to the US Dollar. If a fall in the demand for Canadian-produced goods relative to US-produced goods caused a recession in Canada, . . .”
It causes a recession because the Bank of Canada sells US Dollars for Canadian Dollars, which drains money from the economy?
“Suppose the Bank of Canada pegged the money supply growth rate. If an increased demand for money caused a recession, . . .”
It causes a recession because the Bank of Canada sells money for {X}, which injects money into the economy?
TILT!
My claim, and that of Austrian economics, is that instability of the roaring 20s and the contraction of the money supply in the 30s is due to central bank started in 1914 and making 2.5 times as much money as it had gold. That fiat money is really what has the “cost of macroeconomic instability”.
Well, that and fractional reserves. Banks should be required to sell 10 year bonds to get money for 10 year loans and not allowed to loan out “deposits available on demand” for 10 years. Then you would have really good stability.
V.Cate vs N.Rowe: OK, now this is starting to get good. 😀
Vincent, you write:
“Well, that and fractional reserves. Banks should be required to sell 10 year bonds to get money for 10 year loans and not allowed to loan out “deposits available on demand” for 10 years.”
So you’re in favor of jack-booted government thug bureaucrats smashing down the doors of poor innocent banker capitalists to impose their bureaucratic tyranny and saddle them with oppressive government regulations? Haha 😀
Min: “It causes a recession because the Bank of Canada sells money for {X}, which injects money into the economy?”
No. It causes a recession because the Bank of Canada does not sell money, so we get an excess demand for money, which causes a recession.
Vincent: suppose, hypothetically, that alchemists discovered a cheap way to convert iron into gold. Think how much inflation that would cause, under the gold standard. Or, a little less hypothetically, suppose that the people who like to own gold bars, and gold jewelry, suddenly got wealthier. Think how much deflation that would cause, under the gold standard. Or, not at all hypothetically, think how much the price of gold has fluctuated, relative to the CPI, over the last decade, and think how much the CPI would need to have fluctuated to get the same fluctuations in the relative price of gold, if the dollar price of gold had been fixed.
… oh shoot!, I forgot to add “and hold them at gun-point” … that’s always important to note!
Given how many billions have been spent just trying to make fusion of hydrogen work, the odds of alchemists discovering a cheap way to make gold seem acceptably low. I would much rather take the risk of that than the risk that politicians might get control of the printing press and print lots of money.
Gold guys look at the price 2000 years ago for a toga and sandals being about 1 oz of gold and the price of a nice suit and shoes today being roughly 1 oz of gold and say that the value of gold is reasonably stable. A gallon of gas in the 1950s was about a dime, or 1/10th of an oz of silver. Today it is around 1/10th of an oz of silver. It is really the dollar that is not stable.
Now Tom, don’t try to start a fight! And this is really wandering off-topic. This post is not about the gold standard, or Austrian economics. It’s about macro and finance.
I do happen to think more bankers should be locked up. 🙂
I think it is really a kind of fraud to tell depositors they can have their money on demand and then loan the money out long term. If too many people demand their money at the same time the bank can not do as it promised. So it is really fraud in my book and should be against the law.
Instead of requiring banks to sell 10 year bonds to make 10 year loans the government made a central bank that could make money to bail out banks. To me this cure is worse than the original problem.
I usually enjoy the fights Tom gets me into. Thanks Tom for the link to this post. 🙂 I am off on a small island in the Caribbean without enough local people to argue economics with but not really enough time to find all the good arguments to get into. Appreciate the help Tom. 🙂
Nick, shoot… I’m busted! … but cut me some slack, it’s my birthday! …and there’s nothing I like more than a good ole MMist vs Austrian dust up. … well I guess I’ll go elsewhere to try and stir up trouble. 😀
Happy birthday Tom!
Vincent: isn’t Warren Mosler also on a small island in the Caribbean? He would be good for an argument. (Totally off-topic: I can’t figure out how a really serious car guy like Warren could live on a small island, unless maybe there are no speed limits??)
Thanks Nick, … and you’re welcome Vince. The pleasure’s all mine.
Happy Birthday Tom!
Ya, Warren is on the next island West of here. Lots of windy roads that could be fun in a small sports car but nothing for going really fast that I ever saw.
“When fluctuations in the demand for money became macroeconomically important, we dropped money growth targeting.”
Nick, I believe you are going to have to define “money”.
Does “money” = medium of account (MOA) = monetary base (currency plus central bank reserves)?
Or, does “money” = medium of account (MOA) = currency plus demand deposits?
If MOA = monetary base, then finance probably won’t matter.
If MOA = currency plus demand deposits, then finance will matter.
Nick’s post said: “Vincent: yes, with 100% gold reserves, the central bank can maintain gold convertibility if it wants to. But would it want to, if the cost is macroeconomic instability.”
I wouldn’t call it macroeconomic instability. I’d call it a shortage of MOA. Vincent probably believes in price deflation.
Moi: “It causes a recession because the Bank of Canada sells money for {X}, which injects money into the economy?”
Nick Rowe: “No. It causes a recession because the Bank of Canada does not sell money, so we get an excess demand for money, which causes a recession.”
So in the first two cases, it is the actions of the Bank to drain money from the economy that causes a recession, while in the last case it is the inaction of the Bank to ward off an incipient recession that allows a recession to happen. Right?
Nick,
We should now change monetary policy to make interest rate differentials macroeconomically unimportant.
What would this mean in the context of a classic bank-run-style financial panic, i.e. a macroeconomic shock due to a sudden Diamond-Dybvig equilibrium shift? The only interpretation I can think of would be a consistent policy of last-resort lending to every financial institution that has any kind of maturity-mismatch between its debts and assets, but this would clearly run into well-known problems. Or am I completely missing the point here?
Vincent Cate,
I’m in 90% agreement with your point that “I think it is really a kind of fraud to tell depositors they can have their money on demand and then loan the money out long term.” Though to be accurate (and re-phrasing your sentence a bit) the fraud at the heart of fractional reserve banking is thus.
“It is really a fraud to tell depositors they can have their money on demand and then loan the money in a less than 100% safe manner”. The fact that banks run risks with depositors’ money means it’s a statistical certainty that sooner or later the risks don’t pay off and the bank is bust. And the fact is that banks have been going bust regular as clockwork throughout history.
The solution is the Milton Friedman / Lawrence Kotlikoff / James Tobin system. Under that system loans are funded only by shareholders (that’s people who knowingly take risks). And as to conventional deposits, banks are barred from taking any risks with that money.
Vincent, it seems that Nick would agree there, at least to a point. And Interfluidity/Steve Waldman has raised similar points in the past. Banks in the modern sense arose as a real kludgy way to make long-term, risky investment compatible with a desire for nominally stable returns, in a world where finance was far less developed and marlets /were way less liquid than they are today.
ISTM that we would be better off if all investment was ultimately funded through a combination of non-banking finance, plus options (or derivatives, more generally) to transfer risks to those who are most willing to bear them. This way each saver could choose her preferred mix of nominal safety and potential returns.
Is pegging the price of NGDP futures a final destination?
I see three potential problems:
– futures require collateral. When malfunctions in collateral markets will cause a recession, we will be told to pay more attention to collateral.
– Second moments and markets for risk. When the market estimate of second moment of NGDP explodes, sometimes it will cause booms, sometimes it will cause recessions. We will be told to to pay more attention to volatility. Krugman will write posts proclaiming that fiscal spending provides much needed certainty, no matter what the state of the markets for macroeconomic risk.
– ZLB problem and a related problem of optimal IOR rate. Sometimes the central bank will pay too much interest on reserves, sometimes too little. Sometimes it will cause huge losses for central bank, sometimes enormous profits, with losses associated to excess macro stabilization, and profits associated with macro instability. We will be told to pay more attention to Friedman Rule.
Central banks target the yield on short and safe financial assets. If an increase in the demand for short and safe financial assets causes a recession, do we study the relationship between the yields on short and safe assets and the yields on longer and riskier assets? Of do we tell the central bank to stop targeting the price/yield of short and safe financial assets?
Of course, central banks don’t use the yield on short and safe assets as a nominal anchor. The regimes you described, gold, exchange rates, and quantity of money, all involved nominal anchors. The nominal anchor that central banks use now is inflation.
In fact, central banks have always tried to use an interest rate instrument to control these things. With a gold standard, interest rate changes are used to dampen or reverse gold flows. The same thing is done when pegging a currency. And my recollection of M1 money supply targeting involved using an interest rate instrument to control money supply growth. Raise interest rates to slow growth in the quantity of money. Yikes, the increase in interest rates needed to have the desired effect was too great. Interest rates had to be fluctuated to much to keep some measure of the quantity of money growing the targeted amount.
As for inflation targeting:
An increase in the demand for CPI bundles could cause a recession, though that could be corrected by using GDP deflator bundles rather than CPI bundles. However, a decrease in the demand for real GDP bundles (real output) can cause a recession when the target is for the rate of change of the price level. And an expected decrease in the supply of real output can cause a recession with inflation targeting.
All that said, I agree with the main point. When interest rate targeting fails, the solution is to change the target not regulate financial markets so that interest rate targeting works. And when inflation targeting fails, switch to a new target.
Vaidas makes good points about futures targeting. I would have the same concerns, and as a result it’s not clear to me that there is a net advantage to using the futures markets as opposed to merely targeting an internal forecast of NGDP (or preferably NNDI). Obviously the gross advantage is that it takes away the central bank’s opportunity to engage in deception and self-deception by either semi-intentionally biasing the forecast or not trying very hard to hit it. But this strikes me as a relatively minor advantage, at least compared to the generic advantage NGDP level path targeting over flexible (or, even worse, strict) inflation targeting. Level targeting does a lot to keep the central bank honest, even if it’s allowed to use its own forecast and not directly penalized for missing it.
You’ll still get instability if the central bank’s forecast errors are autocorrelated, or if the growth rate of the target path is less than the natural discounted growth rate, or if the target isn’t credible. Those are possible problems, but I don’t think likely. There’s also the question of what the central bank’s ostensible instrument would be at the zero bound — but if we assume that none of my three possible problems arises, then this is pretty much irrelevant: in practice, the instrument at the zero bound is the future interest rate guidance implicit in the NGDP target path (which by assumption is credible), and we shouldn’t spend much time at the zero bound anyhow (since by assumption the nominal growth rate is high enough to avoid it).
Bill: “And my recollection of M1 money supply targeting involved using an interest rate instrument to control money supply growth.”
That is how the Bank of Canada did it in the late 70’s, yes.
“Raise interest rates to slow growth in the quantity of money. Yikes, the increase in interest rates needed to have the desired effect was too great.”
In Canada it was the reverse. The demand for money fell, so inflation did not fall as quickly as the Bank of Canada wanted, and it raised interest rates above that needed for the monetary target.
Vaidas: so the NGDP futures market will be a poor predictor of NGDP? Maybe. Wouldn’t the same problem arise with using the spread between indexed and non-indexed bonds as a predictor of inflation?
Andy: “Level targeting does a lot to keep the central bank honest, even if it’s allowed to use its own forecast and not directly penalized for missing it.”
Good point. It must correct its own past errors. Funny, I had never thought of that. It’s obvious now you mention it!
But all you three guys are jumping ahead of me in this post. I still want to think about the idea that inflation targeting is targeting an interest rate differential. My mind is stuck on that. NGDP, or other alternatives, comes later.
Bill Woolsey said: “Raise interest rates to slow growth in the quantity of money.”
Does “money’ include demand deposits here?
Nick,
Bill Woolsey’s comment makes sense to me, as does your concept interest rate differential targeting.
Combining them (I think) and editing:
– Nominal anchors include land (your recent post), gold, exchange rates, quantity of money, and inflation.
– Central banks use an interest rate instrument for control. They target the yield on short and safe financial assets. With a gold standard, interest rate changes are used to dampen or reverse gold flows. The same thing is done when pegging a currency. And M1 money supply targeting used an interest rate instrument to control money supply growth.
– The interest rate control mechanism can be characterized as targeting an interest rate differential (the policy rate versus the natural rate) in order to target the nominal anchor (whether that’s inflation or any of the other nominal anchors)
I’ve probably messed up the ideal vocabulary at bit, but something like that.
We need to stop relying on private finance to run the economy. Private finance first and foremost make a profit. It is inefficient to have a large portion of investment dollars going to boost obscene profits in finance. Finance is overblown. We need more collective funding of economically critical items. This is best done by taxing the wealthy and using the increase in wealth to pay the balance rather than borrowing money from the wealthy and paying them handsome rewards. Too much finance is basically a tax on the economy with most of the proceeds going to the wealthy. When finance gets too big, shrink it.
Oooh, A Market Montarist, an Austrian, and a Socialist Co-operative Commonwealther. Now all we need is the bar!
Nick, great post. I’d take a different route in terms of analogies. If we’re on a CPI standard, shouldn’t we be paying attention to the CPI market or changing our policy, rather than finance being the pivot? The bits about interest rates seem to me to be a red herring.
When we talk about the “CPI market”, the particular sector at fault might be the largest/most volatile contributor to CPI, energy. Central banks are supposed to target core, but I seem to recall many being worried about headline back in 2006-07 due to the explosion in oil prices. Perhaps central bankers should have gone off the CPI standard since, at the time, the demand for headline CPI units was driving the economy into a recession? Is the macroeconomic importance of oil markets an artifact of a particular monetary policy?
JP_Koning: as long as we confuse the unobservable “pure inflation rate” with a price index whose measurement we don’t adjust fast enough,yes.
As Nick told me a couple years ago, Luxembourg can have the nominal price of oil it wants. I was too busy to reply at that time that yes Luxembourg can have the nominal price of oil in Luxemburger dinar or Grand-Ducal sesterces or whatever cowrie shell they use. But they can’t have the real price they want. And targeting the CPI while you can’t constantly update the basket is trying to get a real price. And you just can’t.
Nick:
“so the NGDP futures market will be a poor predictor of NGDP? Maybe.”
It might become a poor predictor in the future, as everybody fully adjusts to the new policy.
There is also Kocherlakota’s point that market forecast is biased because the value of resouces in catastrophic scenarios is lower and markets adjust for that. Kocherlakota says this is OK as policymakers should perform this adjustment too. But I am not sure how does his argument work in the context of level targeting.
“Wouldn’t the same problem arise with using the spread between indexed and non-indexed bonds as a predictor of inflation?”
Exactly. There is no escape from finance.
One pragmatic solution is to let NGDP futures fluctuate inside a corridor. Let central banks optimize for all the other stuff as long as NGDP futures trade inside the corridor.
JP Koning said: “If we’re on a CPI standard, …”
It seems to me the USA is on a “demand deposit” standard.
Vincent Cate,
There’s nothing that necessarily joins the concepts of checkable demand deposits and reserve banking whether 100% or fractional. Deposits end up being, in effect, equity without any corresponding risk premium.
You could give everyone an account at the Fed and leave business loans to loan trusts, and household mortgages to GSEs (with explicit government guarantees), since the 30 year fixed loan is social policy. It makes no economic sense to the lender with correctly priced risk. It came into being as a remedy for the problems caused by rolling over mortgages in the 1930s.
This doesn’t do much for Nick’s problem, however. You still have to have mechanisms to price risk and transform debt durations. Interest rates govern this process. I’m not sure we could convert entirely to Islamic finance and deal only with equity.
The idea of GSES securitizing Islamic equity mortgages is certainly intriguing, as is the idea of the government issuing trills.
However, as the lender of last resort (ie. last man standing), the government is always the final bearer of extreme tail risk. Attempts to foist this onto the private sector never work, because the variance is infinite, and the risk can’t be fairly priced.
It seems there are two questions here.
Do interest rate differentials need to be controlled, and who should be the ones to do it?
What should the government control instead, and how would it work?
If CPI were a commodity then the Fed could just build huge warehouses and make a market in it, like aluminum speculators do. I can’t quite see how you could do it with CPI derivatives, but maybe I’m missing something.